Bund Rally Halts Near Record-Low Yield as BES Fallout Contained

Lukanyo Mnyanda and David Goodman

July 22, 2014 — 11:33 AM EDTJuly 22, 2014 — 11:33 AM EDT

Germany’s bonds fell, with 10-year yields rising from near a record low, as investors bet the European Central Bank’s backstop was credible enough to repel contagion risks spreading from Portugal’s banking turmoil.

Benchmark bunds pared last week’s gains as rebels in Ukraine began releasing the bodies of the 298 people killed in the shooting down of a Malaysian airliner. German two-year rates matched a three-week high as European stocks advanced. Spain’s 10-year bonds held a five-day gain, resuming a rally that waned this month when a company linked to Portugal’s Banco Espirito Santo SA failed to repay short-term debt.

“It looks like a bit of a reversal,” Hendrik Lodde, a fixed-income strategist at DZ Bank AG in Frankfurt, said, referring to 10-year bund yields. “Equity markets are moving in a positive direction too.”

Germany’s 10-year yields rose two basis points, or 0.02 percentage point, to 1.17 percent as of 4:32 p.m. London time after dropping to 1.136 percent on July 18. That compares with the record-low 1.127 percent set in 2012. The 1.5 percent bund due in May 2024 fell 0.23, or 2.30 euros per 1,000-euro ($1,347) face amount, to 103.02. The nation’s two-year note yielded 0.034 percent, matching the highest since June 30.

The Stoxx Europe 600 Index of shares climbed 1.4 percent after falling 1.5 percent in the previous three days.

ECB Stimulus

The turmoil in markets was contained by a stimulus package announced by the ECB last month, which included charging lenders to park cash with it overnight and targeted cheap loans. That reinforced a rally in the region’s higher-yielding assets that started in 2012 when ECB President Mario Draghi pledged to do whatever it takes to safeguard the euro.

Spain’s 10-year yield was little changed at 2.58 percent, leaving the decline since July 14 at 19 basis points, even as political crises in the Middle East and Ukraine escalated. The rate on similar-maturity Italian debt was 2.78 percent. Portugal’s 10-year yield increased four basis points to 3.71 percent.

“What we’ve seen with the Espirito Santo case was absolutely reassuring,” Jean Medecin, London-based member of the investment committee at Carmignac Gestion, said in an interview on Bloomberg Television’s “On The Move” with Jonathan Ferro. “We have seen no contagion or very little contagion to the overall credit market. Also the sovereign market has reacted in a relatively smooth way.”

The company, which has the equivalent of $68 billion of assets under management, is the biggest holder of Portuguese bonds among institutional investors that disclose ownership, according to data compiled by Bloomberg.

Yield Forecast

German 10-year yields will climb toward 2 percent by the end of 2016 as investors reevaluate how long the ECB will need to keep interest rates at record lows, according to John Higgins, chief markets economist at Capital Economics Ltd. in London.

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“We are not convinced that interest rates will need to remain at rock-bottom indefinitely,” Higgins wrote in a note dated today. “We suspect that investors will eventually conclude instead that the monetary policy cycles in the euro-zone and elsewhere in the West are only likely to be desynchronized for a few years, not decades. As a result, we forecast that the 10-year bund yield will be dragged up towards 2 percent by the end of 2016 by an even more pronounced rise in the yield of 10-year U.S. Treasuries.”

Policy Outlook

While Draghi last month signaled at least another 2 1/2 years of subdued interest rates, investors are betting policy makers in the U.K. and U.S will move faster as economic growth strengthens.

Traders see about a 61 percent chance the Fed will increase its key rate by July 2015, federal funds futures contracts show, and forward contracts based on the sterling overnight interbank average, or Sonia, show investors are betting U.K. borrowing costs will increase 25 basis points by February.